Thursday, November 05, 2009

You'd think investors would have learned a harsh lesson. Let's talk about that after the break:

Concerns are mounting that efforts by governments and central banks to stoke a recovery will create a nasty side effect: asset bubbles in real-estate, stock and currency markets, especially in Asia.

The World Bank warned Tuesday that the sudden reappearance of billions of dollars in investment capital in East Asia is "raising concerns about asset price bubbles" in equity markets across Asia and in real estate in China, Hong Kong, Singapore and Vietnam. Also Tuesday, the International Monetary Fund cited "a risk" that surging Hong Kong asset prices are being driven by a flood of capital "divorced from fundamental forces of supply and demand."

Behind the trend are measures such as cutting interest rates and pumping money into the financial system, which have left parts of the world awash in cash and at risk of bubbles, or run-ups in asset prices beyond what economic fundamentals suggest are reasonable.

Prices are surging across a host of markets. Gold, up about 44% this year, soared to a record high Tuesday. Copper is up about 50% in the past year. In the U.S., risky assets are rising rapidly in price: The risk spreads, or interest-rate premiums, on low-rated junk bonds have narrowed to about where they were in February 2008, before Bear Stearns and Lehman Brothers fell, according to Barclays Capital.

Before I start talking about the "why", let me sum up what you just read because, in truth, my eyes glazed over the first four times I read it, and I'm supposed to be interested in this stuff for a living.

In short, there's a lot of free capital out there that is not being reinvested in companies, or infrastructure, but in speculative investments. The laws of supply and demand, while imperfect, do apply here: opportunities are created when there is more money available than can reasonably be invested/spent.

Those bonuses at Goldman Sachs, that could be lent to struggling shopkeepers or small manufacturers are only the top of the iceberg of available cash that is being used creatively to whip up yet another frenzy.

Why?

Fair question, and a simple answer: addiction.

Greed is a drug. It is like alcohol or heroin, only greed destroys more lives than either of those.

When you've spent the past thirty years receiving double digit percent returns on your invested capital (yes, we've been in an overheated market for that long, despite the occasional bump and drop), you're not going to suddenly accept money market rates of 1 or 1.5% on your money.

You're going to force higher returns. You're going to look for pockets where the worldwide recession has not hit yet, and cycle your money in and out quickly.

How do I know this is what is happening? Personal experience.

Over the past three weeks, I have seen no fewer than three investment funds offer investors refunds on their invested capital. They've called for too much and were unable to complete investments they believed they could close on at an appropriate return.

They were, in other words, outbid by people willing to accept a lower-but-still-healthy return.

How does that work? Here's a thought experiment.

I'm willing to accept a 5% return so I bid to invest one dollar, expecting to get back $1.05.

I do this knowing that I'm faring better than the bank, who would give me a $1.01.

Someone else realizes they'd be willing to accept a 4% return, and so offer to invest $1.01, to get back the same $1.05.

The investment would be foolish to accept less money to pay back more in interest. After all, they get to keep an extra penny themselves.

Greed.

Basically, this is one step up from a Ponzi scheme. And it signals that we are far from out of the woods in this economy.

I'm not sure what the answer is. Part of me would like to see stronger oversight of the markets, but that might stifle true innovation. After all, green energy ain't gonna be financed at the prime rate for the foreseeable future. Neither is stem cell research.

On the other hand, the anarchist in me would like to see the entire capitalist system go cold turkey on stupidity. But that would destroy us in the process, and that kind of violent change only begets more violence.

"Liberals got women the right to vote. Liberals got African-Americans the right to vote. Liberals created Social Security and lifted millions of elderly people out of poverty. Liberals ended segregation. Liberals passed the Civil Rights Act, the Voting Rights Act. Liberals created Medicare. Liberals passed the Clean Air Act, the Clean Water Act. What did Conservatives do? They opposed them on every one of those things...every one! So when you try to hurl that label at my feet, 'Liberal,' as if it were something to be ashamed of, something dirty, something to run away from, it won't work, Senator, because I will pick up that label and I will wear it as a badge of honor." -- Matt Santos, The West Wing